Mortgage Loan Restructuring

The most important role for public policy is to provide incentives for servicers to restructure and modify loans, to make certain that shared appreciation contracts are part of the policy mix, and to address the legal barriers to modifying securitized loans.

My wife says that I became too angry and agitated at the hearing when Ed Pinto suggested that we need a major effort at loan modifications. I do become angry and agitated every time one of these suggestions gets made.

What are the standards that you are going to use to determine eligibility for loan modification?

Many (most?) of the loans that you would be modifying involve fraud. Sometimes, it was the borrower who deliberately committed fraud. But most of the time, it was the mortgage broker. We won't be able to sort that out. So let's assume that fraud gets a free pass.

And, since I'm feeling open-borderish today, I won't hold it against the borrower if he is an illegal immigrant. That still leaves:

1. Homes that are non-owner-occupied. If somebody bought a house to flip, not because they wanted to live in it, why subsidize them any more than they already have been?

2. Next, consider anyone who bought a home with little or no money down. Doing loan modifications for these people amounts to saying, "You saw a really nice house that you wanted. You didn't pay anything for it, and now guess what--we're going to give it to you! We'll do whatever it takes to make sure that you can afford the payments."

I don't think so. The lender owns the house. If the taxpayer is the ultimate lender, then let's sell it to the highest bidder. For these no-money-down buyers, the only thing taxpayers should help with is a moving truck and holding the door for you as you leave.

3. We also have the cash-out refinancers. These are people who may have had equity at some point, but they chose to take it out to buy a boat or go to Vegas or what have you. They could have stuck to living within their means, but they made a different choice. Do you feel like modifying their loans? Neither do I.

4. Next, we have the serial defaulters. These are people who already have had their loans modified and defaulted. Latest reports say that a majority of people with loan mods are defaulting again. Eliminate those folks.

Advocates of loan restrucuring point out that foreclosure is a costly process. Guess what? Loan modifications, particularly in a market like this one where they are likely to fail, can be even costlier. There is a lot of overhead involved in doing loan mod.

What we need is an honest housing market, with legitimate owners, legitimate renters and prices that balance supply and demand. Loan modifications undermine the honesty of the market. They delay the necessary adjustments. With foreclosures, it might take two years for the housing market to find a bottom. With loan mods, it will take at least ten years.

Why is loan restructuring so popular? I think it's because people are in denial. They want to think that there is some feel-good way to avoid severe adjustments in housing. But loan restructuring will worsen the pain, not relieve it.

My idea for softening the landing probably has ridiculously high overhead cost as well, but it might help more than it costs.

The idea is to go ahead with foreclosure or make the occupant sell the property. Part of the loan is paid down. The bank can then collateralize the remaining portion of the debt with properties it is unable to sell, preserving the value of these properties and incentivizing pay off of the remaining debt. It could quickly reshuffle the existing housing inventory.

It seems impractical, but it could be made to work by creating a housing lottery and not actually giving the liability holder an actual property, but a different asset which can be used to buy lottery tickets for certain property classifications.

It could possibly match potential buyers and seller more quickly than foreclosure auctions. The chance element eliminates the need for the buyer to do extensive research or be familiar little know market.

We've seen all three of these here in Orange County, CA. My wife and I did the prudent 30 year fixed rate loan with a chunk of money down. My wife in particular gets very angry when she thinks about the government using our tax dollars subsidizing those around here who spiked the housing boom/bust living far beyond their means with variable rate, liar loan, little money down funny money.

"1. Homes that are non-owner-occupied. If somebody bought a house to flip, not because they wanted to live in it, why subsidize them any more than they already have been?

2. Next, consider anyone who bought a home with little or no money down. Doing loan modifications for these people amounts to saying, "You saw a really nice house that you wanted. You didn't pay anything for it, and now guess what--we're going to give it to you! We'll do whatever it takes to make sure that you can afford the payments."

3. We also have the cash-out refinancers. These are people who may have had equity at some point, but they chose to take it out to buy a boat or go to Vegas or what have you. They could have stuck to living within their means, but they made a different choice."

Because it extends, prolongs, and deepens the problem. This provides additional justification for more intense and more prolonged (permanent?) government interventions. Everything I've read about the federal response to the mortgage loan crisis points to a desire for more regulations, more bureaucracy, and more government oversight.

According to the CBO, federal government revenues are 19% of Gross Domestic Product. I expect that to rise to 25% by the end of Obama's first term due to massively increased federal spending (and taxing) and a lowered GDP due to the recession.

The great majority of the defaulted dollars come from the four "Sand States" of California, Arizona, Nevada, and Florida, especially in exurbs with long commutes to jobs and hot weather in summer. In other words, many would make good winter homes for the huge number of affluent Northern Baby Boomers approaching retirement age. If the government lets their prices fall low enough, they will have willing buyers.

So far, these are ideological categories. Painfully slowly, we are getting data sufficient to shift from ideology to ... "real" policy.

1. Flippers -

7% of all subprime and 22% of alt-A, in 2003-2007 period. IndyMac (California) was a big alt-A lender.

2. 100% LTV customers.

Why do you focus on the responsibility of the borrower, only? If you really believe in free markets, why shouldn't borrowers, from time to time, remind lenders that they have risks, especially the more they make stupid loans? If you set a figure that is slightly better than the lender can get through a costly foreclosure process, that should be sufficient economic incentive for the lender. Society, of course, can weigh the costs of allowing bank foreclosures to ravage communities where lenders were ... as stupid as borrowers.

3. Equity taken out or sucked out

As a group, these continue to be the best capitalized loans in the lot. 80% LTV for subprime and 76% LTV for alt-A. One suspects, a priori, from the long history of this segment market, that this is the field most ripe for predatory lending practices and for those "salesman" who were able to sucker people into taking sub-prime loans, rather than a prime loan that they qualified for. Onerous pre-payment penalties and the like may also often attach to these loans, etc. (71% for all subprime, 42% of alt-A, 2003-2007).

4. Re-defaulters

Re-default is serious. As little as I understand it, the FHA program, which puts FHA lenders at the risk of *treble damages* if they do not actually try to do serious mitigation ("treble damages" is the real language of real-estate, yes?), has a very low re-default rate. So, there are ways to do modifications and ways not to do modifications.

From a macro perspective, the lender can assume that the next marginal buyer is a FICO 700 or greater, right? However, the pool of available 700s may be getting smaller and many may also not be the marginal buyer (most baby boomers may already have a nice home, one that they are about to get re-financed at 4.5%, if rates keep coming down).

I don't have actual figures on this purported supply/demand imbalance, but consider this: we are at 2.25M+ foreclosures a year and 'normal' demand for new, single family housing is ... a little better than half that rate, during *good* times.

So, how long do lenders intend to hold non-income producing REO assets on the balance sheet, just to "make a point", to wait for or find that marginal 700 buyer in their market (in Michigan, Florida, California, Arizona, and Nevada...)?

Put another way, to the extent that easy credit over-supplied the housing market, if lender-owners think they have an 'easy out' through foreclosure, they may be mistaken, in aggregate.

How will we know? Well, assuming they give up holding the assets, they will eventually start cutting prices, aggressively, "giving stuff away", during foreclosure auctions and the like.

How is a potential "overshoot" of that kind going to help anyone? A big overshoot could put even more people under-water, with negative equity. That's a very undesirable adjustment process - too fast and too deep. Smoothing out that adjustment is something that the current Treasury officials and even the Federal Reserve has ... not targeted enough, perhaps.

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